When greed is fact and control is fiction Enron's spectacular collapse was not an isolated financial disaster, says Frank Partnoy. It was symptomatic of a new culture of concealment in business and a reckless disregard of risk
Friday February 14, 2003 The Guardian The 1990s were a decade of persistently rising markets - 10 years of economic expansion, with investors pouring record amounts into stocks and pocketing double-digit returns year after year. The recent stock price boom was the longest-lived bull market since the second world war. Some stocks or sectors suffered periodically, but almost anybody who remained invested throughout the decade made money. During this time, stocks became a part of daily conversation and investors viewed the rapid change and creative destruction among companies as investment opportunities, not reasons for worry. The decade was peppered with financial debacles, but these faded quickly from memory even as they increased in size and complexity. The billion dollar-plus scandals included Robert Citron of Orange County, Nick Leeson of Barings and John Meriwether of Long-Term Capital Management, but the markets merely hiccoughed and then started going up again. When Enron collapsed in late 2001, it shattered some investors' beliefs and took a few other stocks down with it. Then Global Crossing and WorldCom declared bankruptcy, and dozens of corporate scandals materialised as the leading stock indices lost a quarter of their value. Most investors were perplexed. The conventional wisdom was that markets would remain under control, that the few bad apples would be punished and that the financial system overall was not under any serious threat. The conventional wisdom is wrong. Any appearance of control in today's financial markets is only an illusion. Markets have come to the brink of collapse several times in the past decade, with the failures of Enron and Long-Term Capital Management being prominent examples. Today, the risk of system-wide collapse is greater than ever. The truth is that the markets have been - and are - spinning out of control. The relatively simple markets that financial economists had praised during the 1980s as efficient and self-correcting had radically changed by 2002. The closing bell of the New York stock exchange was barely relevant as securities traded 24 hours a day around the world. Financial derivatives were as prevalent as stocks and bonds, and nearly as many assets and liabilities were off-balance sheet as on. Companies' reported earnings were a fiction and financial reports chock-full of disclosures that would shock the average investor if they ever even glanced at them - not that anybody ever did. If investors believe in the fiction of control and ignore the facts, the markets can continue to rise. But if investors question their faith, the downturn will be long and hard. As investment guru James Grant recently put it: "People are not intrinsically greedy. They are only cyclically greedy." There have been three major changes in financial markets in the past 15 years. First, financial instruments became increasingly complex and were used to manipulate earnings and avoid regulation. Second, control and ownership of companies moved apart as even sophisticated investors could not monitor senior managers and even diligent senior managers could not monitor increasingly aggressive employees. Third, markets were deregulated. These changes spread through financial markets like a virus. Before 1990, markets were dominated by the trading of relatively simple assets: mostly stocks and bonds. The sinaqua non of the 1980s was the junk bond, a simple fixed-income instrument no riskier than stock. The merger mania of the 1980s, driven by leveraged buyouts in which an acquirer borrowed heavily to buy a target's stock, involved straightforward transactions in stocks and bonds. Individual investors shied away even from stocks, and most people kept their savings in the bank or in certificates of deposit, which paid more than 10% annual returns during most of the decade. From 1968 to 1990, individuals sold more stock than they bought and money flowed out of the market. Birth of derivatives Derivatives - the now notorious financial instruments whose value is derived from other assets - were virtually unknown. The two basic types of derivatives, options and futures, were traded on regulated exchanges and enabled parties to reduce or refocus their risks in ways that improved the overall efficiency of the economy. Customised, over-the-counter derivatives markets, often used for less laudable purposes, were less than 1% of their present size, and most complex financial instruments still had not been invented. In Barbarians at the Gate, the classic book about 1980s finance, derivatives are not even listed in the index. Some companies used basic forms of derivatives in the 1980s, including "plain-vanilla" interest rate swaps. But the forms of structured financing and gizmos that later would bring hundreds of companies to their knees simply did not exist. Even stock options, the primary source of executive compensation in the 1990s, were relatively uncommon. The legal environment in this period was harsh. The go-go 1980s led prosecutors to clamp down hard on securities fraud, indicting dozens of financial market participants. The financial market watchdogs made investors feel secure - almost smug - about financial fraud. Even highly paid investment bankers were technologically primitive, without email or internet. They used calculators instead of computer spreadsheets and statistical software. Few had formal finance training, and almost nobody had a maths or finance PhD. Individuals were technologically primitive, too. Investors placed orders to buy and sell stock by letter or phone, not with the click of a mouse. People learned how their stocks were performing at most once a day, from the newspaper, not in real time on TV. Financial analysis was available through the mail at a price, not on the internet for free. In sum, the 1980s were a relatively primitive period on Wall Street. Life was uncomplicated if aggressive. The financial markets became increasingly competitive and profit margins dwindled. The crash of October 1987 didn't help. After the Dow Jones tumbled more than 7% in a day, investors became skittish and investment bankers' business faltered. The last years of the decade were likely to be lean, and the future looked grim. It was not a good time to be working on Wall Street. But all of this was about to change. Cash conversion By 2002, most people knew the basic story of Enron: how three radically different characters - the professorial founder Kenneth Lay, the free market consultant Jeffrey Skilling and the brash financial whizz Andrew Fastow - converted a small natural gas producer into the seventh largest company in the United States, on the way generating fabulous wealth for shareholders, employees - and particularly insiders, who cashed out more than $1.2bn. Most people also knew about Enron's spectacular fall into bankruptcy, the thousands of lay-offs, the imploded retirement plans, the controversy surrounding political contributions and even the details of executives' personal lives. But the basic story was unsatisfying, because by focusing on just a few transactions and people it failed to place Enron in perspective. Simply put, 15 years ago Enron could not have happened. It was made possible by the spread of financial innovation, loss of control and deregulation in financial markets. Enron's managers - with the assistance of accountants at Arthur Andersen and several Wall Street banks - used complex financial instruments and engineering to manipulate earnings and avoid regulation. Enron's shareholders lost control of the firm's managers, who in turn lost control of employees, particularly financial officers and traders. Enron oper ated in newly deregulated energy and derivatives markets, where participants were constrained only by the morals of the marketplace. Enron's officers combined the risky strategies of Wall Street bankers with the deceitful practices of corporate CEOs in ways investors previously had not imagined. Even after more than a year of intense media scrutiny, congressional hearings and other government investigations, most of the firm's dealings remained unpenetrated. A special committee appointed to decipher Enron's collapse spent several months reviewing documents and interviewing key parties, but its 200-page report covered just a few of Enron's thousands of partnerships and was filled with caveats about its own incompleteness. Congress held dozens of hearings but barely scratched the surface. Incredibly, after Enron's bankruptcy, its own officials were unable to grasp enough detail to issue an annual report; even with the help of a new team of accountants from PricewaterhouseCoopers, they simply could not add up the assets and liabilities. A close analysis of the dealings at Enron leads to three key conclusions, each counter to the prevailing wisdom about the company. First, Enron was in reality a derivatives trading firm not an energy firm, and it took on much more risk than anyone realised. By the end, Enron was even more volatile than a highly leveraged Wall Street investment bank, although few investors were aware of it. Second, the core business of derivatives trading was actually highly profitable - so profitable, in fact, that Enron almost certainly would have survived if key parties had understood the details of its business. Instead, in late 2001, Enron was hoist with its own petard, collapsing not because it wasn't making money but because institutional investors and credit-rating agencies abandoned the company when they learned that Enron's executives had been using derivatives to hide the risky nature of their business. Third, Enron was arguably following the letter of the law in nearly all of its dealings, including deals involving off-balance sheet partnerships and infamous special purpose entities. These deals, which blatantly benefited a few Enron employees at the expense of shareholders, nevertheless were disclosed in its financial statements, and although these disclosures were garbled and opaque, anyone reading them carefully would have understood the basics of Enron's self-dealing - or, at a minimum, been warned to ask more questions before buying the stock. Illegal or alegal? To the extent that Enron, its accountants and bankers were aggressive in transactions designed to inflate profits or hide losses, they weren't alone. Dozens of other companies were doing the same kind of deals - some with Enron - and all had strong arguments that their deals were legal, even if they violated common sense. Relative to many of its peers, Enron was a profitable, well run and law-abiding firm. That does not mean it was a model of corporate behaviour - it obviously was not. But it does explain how Enron could have happened. Although the media seized on its collapse as the business scandal of the decade, the truth was that Enron was no worse than Bankers Trust, Orange County, Cendant, Long-Term Capital Management, CS First Boston, Merrill Lynch and many others to follow, including Global Crossing and WorldCom, which collapsed soon after Enron. Enron's dealings were not illegal, they were alegal, and Enron was a big story - not in itself but as a symbol of how 15 years of changes in law and culture had converted reprehensible actions into behaviour that was outside the law and therefore seemed perfectly appropriate, given the circumstances.
